My opinions on value investing. The idea is to create a value discussion on stocks and concepts. You might find this blog leaning a bit towards Dalal Street but the concepts should travel well across global markets.
Please note that I may or may not have a position in these stocks. Please use these opinions after through independent research and at your own risk.

Pages

Sunday, April 26, 2015

Macro factors: Corporate profits to GDP

"In my opinion, you have to be wildly optimistic
to believe that corporate profits as a percent of GDP can, for any sustained
period, hold much above 6%. One thing keeping the percentage down will be
competition, which is alive and well. In addition, there's a public-policy
point: If corporate investors, in aggregate, are going to eat an ever-growing
portion of the American economic pie, some other group will have to settle for
a smaller portion. That would justifiably raise political problems—and in my
view a major reslicing of the pie just isn't going to happen."

Warren
Buffett

While
doing some research for a completely orthogonal topic to this one, I found a
Buffett saying similar to the one above. That got me thinking about why Buffett
says the magical 6% number. Putting that 6% number together with his quote on
total market cap to GDP being under 1x we can conclude that he believes the
maximum price to earnings for all companies should be 1/6% or 16.67. The
average P/E over the last 16 years of the NIFTY in India is 18.48 which is
consistent with this notion as well.

Let’s
look at the history of this macro factor: corporate profits to GDP in India:

Overall this
graph does not show that there is an earnings bubble. In fact if anything it shows
that corporate profits might be at a low. At the time of this writing in April 2015
the NIFTY P/E is somewhere around the 87.5 percentile mark which may indicate a
bit of a bubble developing but this factor says the opposite.

Why is this
relevant for Value investing (because I think macro betting is exactly what value investing aims to avoid)? It is relevant because some of these factors can give
you pointers into a bubble developing and if you can just increase your cash % by
just 20% (more is better) before each bubble and sit out the highs the chances of
you beating the index are higher. Now the index high in 2010-11 was probably harder
to call but the 2008 case is fairly obvious on 20:20 hindsight of course. If the
corporate profits to earnings are north of 7% and the index P/E is north of the
87.5 percentile mark it’s probably time to be scared. Now imagine if at that point
an investor exited and sat on cash until the index P/E hit the average, the outcome
would most definitely ensure index out performance.